It's too early to start celebrating. That's the sober message from the Federal Reserve – if you give it half a chance, the markets won't heed it.
In a news conference on Wednesday and in written statements after its last policy meeting, the Fed did everything it could to curb Wall Street's enthusiasm.
“It is far too early to declare victory and risks certainly remain,” said Jerome H. Powell, the Fed chairman. But stocks still soared, and the S&P 500 was on the verge of a new record.
The Fed suggested that it was still too early to expect a “soft landing” in the economy – a decline in inflation without a recession – although that is increasingly the consensus on Wall Street. An early decline in the federal funds rate, the short-term benchmark interest rate that the Fed directly controls, is also not a sure thing, although Mr. Powell said the Fed had begun discussing rate cuts and markets were growing concerned. count on them.
Markets have been on the rise since July – and positive since the end of October – on the assumption that really good times are ahead. That could prove to be a correct assumption — one that could help President Biden and the rest of the Democratic Party in the 2024 election.
But if you were looking for certainty about a cheerful 2024, the Fed didn't provide it at this week's meeting. Instead, it went out of its way to say that it was designed for maximum flexibility. Prudent investors may want to do the same.
Reasons for optimism
On Wednesday, the Fed announced that it would keep the key interest rate at its current level of around 5.3 percent. That is around 5 full percentage points more than at the beginning of 2022.
Inflation, the glaring economic problem at the start of the year, has fallen sharply thanks in part to these sharp interest rate hikes. The consumer price index rose 3.1 percent in the year to November. That was still well above the Fed's target of 2 percent, but well below the inflation peak of 9.1 percent in June 2022. And because inflation has fallen, a virtuous cycle has developed from the Fed's perspective. Since the key interest rate is well above the inflation rate, the real interest rate has risen since July without the Fed having to take direct action.
But Mr Powell says interest rates need to be “sufficiently restrictive” to ensure inflation does not rise again. And he warned: “We need to see more evidence to be confident that inflation is moving towards our target.”
The wonderful thing about the Fed's rate hike so far is that it hasn't triggered a sharp rise in unemployment. According to current figures, the unemployment rate in November was only 3.7 percent. On a historical basis, this is an exceptionally low rate and is associated with a robust, rather than a weak, economy. Economic growth accelerated in the three months to September (third quarter), with gross domestic product rising 4.9 percent annually. This looks nothing like the recession that was widely expected a year ago.
On the contrary, with such indicators of robust economic growth, it is no wonder that longer-term interest rates in the bond market have fallen in anticipation of Fed rate cuts. The federal funding futures market on Wednesday forecast cuts in federal funding starting in March. By the end of 2024, the futures market expects the federal funds rate to fall to below 4 percent.
But on Wednesday, the Fed forecast a slower and more moderate decline, putting the interest rate at around 4.6 percent.
Too early to relax
Several other indicators are less positive than the markets. The interest rate pattern for government bonds known as the yield curve has been predicting a recession since November 8, 2022. Short-term interest rates – particularly on three-month Treasury bonds – are higher than longer-term ones – particularly on 10-year Treasury bonds. In financial jargon, it is an “inverted yield curve,” which often predicts a recession.
Another proven economic indicator was the warning of a recession. The Leading Economic Indicators, an index formulated by the Conference Board, an independent economic think tank, “signals a recession in the near future,” Justyna Zabinska-La Monica, a senior manager at the Conference Board, said in a statement.
The consensus of economists, as measured by independent surveys by Bloomberg and Blue Chip Economic Indicators, predicts no more recession in the next 12 months – reversing the prevailing view earlier this year. But more than 30 percent of economists in the Bloomberg survey and a whopping 47 percent of those in the Blue Chip Economic Indicators disagree and believe there will actually be a recession next year.
While economic growth, as measured by gross domestic product, has increased sharply, initial data shows it is slowing significantly as high interest rates gradually hurt consumers, small businesses, the real estate market and more. For two years, fiscal stimulus from residual pandemic aid and from Deficit spending reflects the restrictive efforts of monetary policy. Consumers are resolutely spending money in stores and restaurants, helping to stave off an economic downturn.
Still, a parallel measure of economic growth – gross domestic income – was significantly lower than GDP last year. Gross domestic income has sometimes been more reliable in measuring downturns in the short run. Ultimately, the two measures will be brought into line, but which direction will only become clear in months.
The markets
The stock and bond markets are eager for an end to monetary policy.
The US stock market has already struggled higher this year and is almost back to its January 2022 peak. And after the worst year in modern times for bonds in 2022, market returns for the year are now positive for investment grade bonds Bond funds that track the benchmark Bloomberg US Aggregate Bond Index and are part of core investment portfolios.
But based on corporate earnings and revenue, U.S. stock prices are stretched, and bond market returns reflect the consensus view that a soft landing for the economy is all but certain.
These market movements may well be justified. But they suggest a near-perfect Goldilocks economy: Inflation will continue to fall, allowing the Fed to cut interest rates early enough to prevent economic catastrophe.
But excessive market exuberance itself could upend that outcome. Mr. Powell has spoken frequently about the tightening and easing of financial conditions in the economy, determined in part by the level and direction of stock and bond markets. Too big a recovery, too soon, could prompt the Fed to delay rate cuts.
All of this will have implications for the 2024 elections. Prosperity tends to favor incumbents. Recessions tend to favor challengers. It is still too early to make a safe bet.
Without specific knowledge, most investors can be best prepared for any eventuality. That means staying diversified, with a broad holding of stocks and bonds. Hang in there and hope for the best.
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